In the second quarter of 2019, the S&P 500 Index generated total returns of 4.3%. Although most major equity markets held the majority of their healthy gains from the first quarter, market volatility returned and weighed on major indices across the world. After achieving a new all-time high in late April, the S&P 500 fell 6.8% in the middle of the quarter, then recovered to a new high in late June. In May and June, the equity markets were especially affected by the economic uncertainty from U.S.–China trade tensions and a broad-based slow-down in global economic growth.
The table below shows the performance of major equity indices for selected time periods.
Equity Performance for Periods Ending on June 30, 2019
|Total Return Index||Market Sector||Quarter||YTD||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||4.3%||18.5%||10.4%||14.2%||10.7%||14.7%|
|Russell 2000||Small U.S. Companies||2.1%||17.0%||-3.3%||12.3%||7.1%||13.5%|
|MSCI EAFE||Developed Int’l Markets||3.7%||14.0%||1.1%||9.1%||2.3%||6.9%|
|MSCI EM||Emerging Int’l Markets||-0.6%||10.6%||1.2%||10.7%||2.5%||5.8%|
While the S&P 500 Index closed the second quarter just shy of its record high, the other market sectors shown above are still trading in correction territory–more than 10% below their 2018 highs. In addition, each of these market sectors (other than the S&P 500) demonstrated weak performance for the preceding one-year period. It is apparent that in this stretch of economic and political uncertainty, investors are more comfortable with large U.S. companies and remain wary of small companies and foreign markets. While the S&P 500 trades near its high, a healthy and sustained advancement in all key equity indices will likely require a reduction in the perceived risk related to the global economic environment.
Monetary policy by most major central banks around world continued to shift to an accommodative stance as the quarter progressed. This policy shift, along with declining interest rates across the globe, was the dominant positive factor for equity markets. Slowing global growth heavily influenced by the escalating U.S.–China trade dispute was increasingly confirmed by weaker economic data and lower inflation in most major economies. The purchase of foreign debt securities by central banks in an effort to keep interest rates low and stimulate their economies has contributed to an unprecedented situation in which over $13 trillion of global debt is now trading at negative interest rates.
While U.S. interest rates are structurally much higher than for most developed economies such as the European Union and Japan, the Federal Reserve has signaled a significant shift in its thinking. The ten-year Treasury bond was yielding as high as 3.23% on November 8, 2018, when the Fed was fairly committed to implementing three 0.25% rate hikes in 2019. Today, this U.S. benchmark is now at 2.00% (down 0.41% in the second quarter) as the Federal Reserve board now contemplates rate cuts later this year. This significant shift in interest rate posture by the Fed and most global central banks will mostly likely act as a positive catalyst for equity returns in the future provided economic activity increases in the face of easier financing and a cheaper money supply throughout the global financial system. In response to these developments, the Bloomberg Barclays Aggregate Bond Index, the broadest benchmark for the U.S. taxable bond market, generated returns of 3.1% in the quarter and 6.1% year-to-date. We continue to regard long-term fixed income investments as relatively unattractive due to their low yields and the risk related to rising interest rates.
The U.S.–China trade tensions and the imposition of tariffs proved to be the most significant negative factor affecting markets this quarter. The stakes for global influence and long-term economic dominance and influence are very high. Byron Wien of Blackstone remarked in his latest Market Views commentary, “China’s competitiveness is the most important issue facing the U.S. China is already the largest economy in world on a purchasing power parity basis and will be the largest by GDP by the 2030’s.” Based on what China spends on research and development relative to the U.S., and its success in producing more than eight times the number of STEM graduates compared to the U.S. each year, the stakes are considerably high on many economic and geopolitical fronts. It is understandable that when the relations deteriorate between the world’s two largest super powers, the rest of the global economy starts to “catch a cold” with regard to business activity and confidence. According to Ned Davis Research, global exports are now the weakest since 2012. It is fair to conclude that until an agreement of some form is made, markets may struggle to make meaningful gains.
Equity investors also seem to be contemplating whether an earnings recession is approaching. Per FactSet Research, the S&P 500 is expecting an earnings decline of 2.6% in the second quarter. This would mark the first time the index has seen two consecutive quarters of year-over-year declines since the first and second quarters of 2016. It is normal for earnings to ebb and flow, and a weaker year does not mean the end of a bull market. For example, going back to 2016, weak earnings in the early part of the year led to a market correction, which proved to be a great equity buying opportunity as profits later recovered. Looking at the third quarter of 2019, only two of the eleven sectors in the S&P 500 are forecast to experience a year-over-year earnings decline. Energy ( 13.6%) and Technology ( 9.8%) are seeing weakness from navigating the trade tariffs and the global slowdown. Corporate profit margins hit their highest level on record in the fourth quarter of 2018, but could be at risk for contraction. With a strong employment picture, wage growth has tracked surprisingly below what would normally be expected in a full employment market. If wage growth starts to accelerate and trade tariffs add to product costs, profit margins will decline unless companies are able to pass this inflation on to consumers by increasing prices.
Valuation for the S&P 500 while not compelling, still looks to be reasonable. According to FactSet Research, the price-to-earnings (P/E) ratio for the next 12 months is approximately 16.7. The 5-year average is 16.5 and the 10-year average is 14.8. At these levels, it is important that earnings continue to increase at an attractive and sustainable growth rate. While the overall market valuation appears to be reasonable, there is a wide divergence in valuation across the entire market spectrum. Jefferies (an investment banking firm) recently commented that the forward P/E of the top quartile of S&P 500 stocks is trading at 28 times earnings and the lowest quartile trades at 10 times earnings. Generally, the high P/E stocks have greater earnings growth potential and lower P/E companies tend to be more mature with higher dividend yields. While our investment philosophy attempts to include both types of companies in portfolios, it is becoming more difficult to find growth companies that are reasonably priced.
In conclusion, we continue to see a complicated mix of both positive and negative global economic and geopolitical data. Fortunately, Vista’s investment process is not highly dependent on forecasting near-term events or economic conditions, as we believe this is a nearly impossible task. We believe long-term investment goals can be achieved by maintaining an asset mix that is appropriate for an investor’s objectives and risk tolerance, utilizing diversification to control risk, and owning investments that are reasonably valued while offering attractive return potential.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.